Accruals are income earned or revenues incurred that are recorded as transactions occur rather than when actual payments are made or received by a business.
To understand how accrual accounting can be beneficial to managing your business’s finances, it’s important to take a look at how accruals work for both revenue and expenses.
Definition and Examples of Accruals
Accruals, which are the basis of the accrual method of accounting, refer to revenue and expenses recorded in a general ledger as invoices are distributed—not when a payment has been sent or received by a vendor. As payments are made, entries are adjusted as a paid expense or income received.
Accrual income is reported as gross income when:
- A business receives a payment
- Income is due to be paid to a business
- When a business earns revenue
- If a title (on the property) is passed on to the business as part of a transaction
In contrast, an accountant or bookkeeper can defer accrued expenses when:
- Services or property are provided to clients
- The business has recovered a liability
Businesses that produce or sell merchandise and maintain inventory (i.e. retailers) must use the accrual method for purchases and sales unless they qualify for the Exception for Small Business Taxpayers.
Example of Accrued Revenue
Accrued revenue is income that’s earned by the business but has yet to be billed to or received from the client or customer. An example of accrual of revenues would be a contractor completing a job for a homeowner. Throughout December, the contractor is completing work for their client. However, the contractor does not send an invoice until all work has been completed. The client would receive their bill in January. The contractor adjusts its financial statement so that:
- Income for December and the new year will be reported as earned by the contractor
- The Dec. 31 balance sheet will include the income the contractor should expect to receive from all clients.
Example of Accrued Expense
An example of an accrued expense would be a landlord of a large building replacing the boiler in December—the last month of an accounting year. However, the company, or tenant, will not pay the bill until an invoice is received in January. Using the accrual method, a bookkeeper or accountant must:
- Record the liability or expense on the balance sheet in the previous year.
- Report the repair and its expense on the income statement for the current year.
A business’s expenses can include any costs related to running the company such as rent, utilities, office supplies, property, equipment, and payroll.
How Accruals Work
In the accrual method of accounting, businesses will report income in the year it is earned, while expenses will also be recorded in the year they were incurred. The purpose of accruals is to ensure that businesses match their income and expenses accurately within an accounting year.
Business accounting software can help entrepreneurs monitor their accrued accounts.
In terms of taxes, accrual accounting requires companies to pay taxes on income that is still owed, meaning you generally report income in the tax year you earn it, regardless of when payment is received. The same goes for expenses, which you deduct in the tax year you incur them, regardless of when payment is made.
Small businesses such as microbusinesses and sole proprietorships that file individual taxes and likely earn less revenue than corporations and partnerships do not have to use accrual accounting to manage their finances. Under the 2017 Tax Cuts and Jobs Act, the IRS allows small businesses generating less than $25 million in annual gross receipts from the three previous tax years that are not in a tax shelter to opt for cash accounting instead of accrual.
If you choose to change your accounting method to use the accrual accounting method, your business must file Form 3115 for IRS approval.
While accrual accounting may be considered a more complex method than cash accounting, it can provide bookkeepers and accountants with a more accurate long-term view of a business’s finances.
- Accrual accounting is an accounting method that records income and expenses as the transactions occur instead of when payments are received or made.
- The purpose of accrual accounting is to balance income and expenses within the same period.
- The accrual method of accounting differs from cash accounting, which records transactions when income is received or payments are made by the business.
- Businesses that generate under $25 million in annual gross receipts from the three preceding tax years can choose cash accounting over accrual.